In QDROs, what is “equalization”?
Divorcing couples often “equalize” their retirement accounts. Is this a good idea? What does it mean? What pitfalls should they be aware of?
To begin with, suppose Mr. Smith has a 401(k) with $100,000.00 and Ms. Smith has a 401(k) with $50,000.00. The money in both accounts was earned entirely during the marriage. They spend some time negotiating, perhaps through counsel or with a mediator, and decide that each account is half Mr. Smith’s and half Ms. Smith’s.
So, they sit down and think about what they should do to move the money.
One option might be to make two transfers: first, Mr. Smith gives Ms. Smith $50,000.00 from his account and, second, Ms. Smith gives Mr. Smith $25,000.00 from her account. But that would involve two transfers and two QDROs.
Is there a way to do it with one transfer?
Yes. The other option might be for Mr. Smith and Ms. Smith to figure out how much would have to be transferred from the larger account (Mr. Smith) to the smaller account (Ms. Smith) so that Mr. Smith and Ms. Smith each end up with the same amount. It would be a single transfer. That is what we mean by “equalization.”
The equalization of accounts is a transfer from one party to another party such that each party ends up with one half (½) of the accounts.
In this case, with two accounts (one with $100,000.00 and the other with $50,000.00) with a total value of $150,000.00, our end goal is for each party to get $75,000.00 (which is one half of $150,000.00.) So, Mr. Smith would only need to transfer $25,000.00, reducing the balance of his account to $75,000.00 and bringing the balance of Ms. Smith’s account up to $75,000.00.
Is it a good idea?
As with so many things, it depends. Clearly, as we described above, it’s usually easier to do one transfer instead of two. However, there are some pitfalls to be wary of. Here are just a few:
- Contemporaneous Balances. Equalization requires the parties to perform a calculation based on roughly contemporaneous balances. An account is usually valued using a monthly periodic statement, so equalization (provided the parties agree) can probably be performed using statements from the same months. If, however, the statements are of different years, the account balances would have changed such the calculation would probably be distorted.
- “Apples and Oranges.” You can’t mix apples and oranges, the old saying goes. The same holds true for equalizations. While 401(k)s can usually be equalized with 401(k)s, retirement accounts (such as IRAs) treat taxes differently. That is to say a dollar in an IRA may not be equal to a 401(k), so mixing different types of accounts may favor one party over another.
- Pensions. We have been discussing defined contribution plans, plans like 401(k)s and IRAs, which are similar to bank accounts in that they have total dollar amounts. Traditional pensions, or defined benefit plans, are different in that they are payments which will be paid out every month. There is no easy way to equalize a pension and 410k.
- Loans. Parties can take loans on 401(k)s. Although these usually appear on periodic statements, the “balance” on the account may or may not include the loan. It may not be clear if balances represent the actual money in the account or the money which will be once the loan is repaid.
- Repaying the Loans. The parties need to be careful to be sure that they are thinking through how the loan is being treated. If the loan is included in the account balance (lowering the balance), then there will be less money to divide, and the equalization amount will be lowered.
For divorcing couples, whether to equalize retirement accounts and how to go about it can be a difficult process. If you’d like any assistance with equalization or any thing else related to QDROs, please feel free to reach out to Weinberg & Schwartz.
